Federal Deposit
Insurance Corporation

July 18, 2003

Federal Reserve Board
Attn: Vice-Chairman Roger W. Ferguson, Jr.
Copy to regs.comments a,federalreserve.gov

Federal Deposit Insurance Corporation
Attn: Chairman Donald E. Powell Copy to comments(ci),fdic.gov

Office of the Comptroller of the Currency
Attn: Comptroller John D. Hawke, Jr.
Copy to regs.commentsa occ.treas.gov

Office of Thrift Supervision
Attn: Director James E. Gilleran
Copy to regs.comments(a ots.treas.gov

RE: Comment on Basel H's Advance Notice of Proposed Rulemaking (ANPR)

Dear Sirs:

During our 40 years in the residential mortgage lending business, we have consistently advocated for reforms to improve the profitability and viability of the banking industry, including calling for appropriate capital requirements. We are alarmed by the prospect of a new Basel II capital regime that would give banks worldwide, including the nation's largest banks, the ability and incentive to sink to the lowest denominator of capital they can get away with. Such a regime is incompatible with promoting safety and soundness in the banking system.

We strongly urge U.S. regulators and legislators not to adopt Basel II as it has been proposed. Instead, a more productive and responsible approach would be to: (1) re-examine and adjust, as appropriate, Basel I's risk-weights and categories and (2) improve the imperfections and inconsistencies in the supervisory process. We strongly support the position articulated in the ANPR that U.S. banking organizations should continue to be subject to a leverage ratio requirement as described under existing prompt corrective action legislation and implementing regulations, regardless of the risk-based capital accord that is in place. We propose that these leverage ratios should only be able to be revised or waived by legislative action. We also urge U.S. representatives on the Basel Committee to insist that the same minimum leverage ratios be required world-wide so there is a capital safety net for the international banking system.

Fundamental Requirements of any Capital Regulation

In our view, any capital regulation needs to be able to achieve the following:

(1) Maximize the safety and soundness in the international banking system by ensuring that sufficient capital is available as a cushion against mistakes or unanticipated crises.

(2) Provide a fair and level playing field for all participants, so that no banking institution is advantaged or disadvantaged because of their size or geographic location.

(3) Try to synchronize capital levels with the relative risk of different instruments and borrowers.

(4) Enable regulators and supervisory personnel to readily understand the capital rules and ensure that adequate resources are available to provide effective supervision.

(5) Be transparent enough to enable boards of directors, senior management and business managers to direct and oversee the bank's capital program.

(6) Create appropriate incentives for banks to maintain sufficient capital levels (and disincentives to maintain inadequate levels).

(7) Provide a means for investors and other third parties to assess the adequacy of a bank's capital ratios.

As discussed below, we believe a modernized Basel I can effectively meet these standards, while Basel U will fall dangerously short by placing undue emphasis on risk sensitivity (#3 above) to the detriment of the other objectives.

A Modernized Basel I is a Better Solution

While Basel I may need some incremental improvements to continue to meet the standards described above, its rules are simple enough to be understood by all interested parties, it has substantially leveled the playing field for banks that compete under different regulatory systems, and it has a decade-long track record of not creating or exacerbating any crises.

We are not persuaded that the commonly cited criticisms of Basel I justify an overhaul of global capital rules that would disrupt settled markets and enable banks, for the first time, to pick their own capital requirements from a self-directed model. First, the one-size-fits-all approach under Basel I works because it is simple enough to be understood by boards of directors and management, applied consistently across all institutions, and monitored effectively by regulators and other market participants. Simplicity promotes stability. When capital rules are understood by all interested parties, it becomes more difficult for the mischievous to fool the ignorant (complexity, by contrast, invites mischief, as evidenced in other complex areas such as derivatives and special purpose entities). If additional risk categories are needed to more closely align capital requirements with risk levels, this can be done without resorting to Basel U's convoluted scheme. The risk-weighting of these categories could also be modernized to better match current knowledge about actual risk exposures. If the U.S. were to adopt Basel II, we believe it should adopt only an approach akin to Basel H's "standardized" approach that continues to assign fixed risk weights to supervisory categories.

Second, if operational risk justifies a separate capital charge, and we are not convinced it does, then Basel I could be revised to, give regulators the authority to determine an appropriate capital augmentation based on a bank's operating history and internal controls. Third, if banks are retaining higher-risk assets after selling or securitizing their lower-risk assets, and if this actually increases the potential for a crisis, then arguably Basel I's capital thresholds should be increased for riskier assets.

Basel II Creates More Problems than Solutions

Basel II is another example of what happens when one puts into a room, for several years, a very bright group of people charged with developing a model to address every perceived imperfection in a highly arcane subject area. The only way for the participants to reconcile their theoretical ideas with the inevitable political concessions is to produce an expansive model that requires hundreds of mind-numbing pages to explain. Even the few experts who may believe they understand the model will be unable to appreciate all the unintended consequences that will result once market forces come into play, including how one or more parties will try to game the new model and force more conservative competitors to fall away or follow suit. We find it all oddly reminiscent of the process that resulted in the debacle of California's so-called energy deregulation, the consequences of which were mild compared to the potentially destabilizing and devastating global consequences under Basel U's privatization of bank regulation.

U.S. regulators should pause to reconsider whether the stability and competitiveness of the U.S. banking system would really be improved by joining the proposed international capital accord. As we see it, the U.S. banking system has proven stronger and more resilient during recent economic cycles than the international bank systems. This can largely be attributed to the tough lessons learned during U.S. bank and thrift crises, including the importance of core (leverage) capital, the need for laws and regulations that encourage financial institutions to act in a safe manner (and that discourage the opposite), and the critical role played by active and informed regulators backed by the strength of prompt corrective action. We believe this strong regulatory framework has contributed to the better performance of U.S. financial institutions relative to non-U.S. banks. Basel II is incompatible with these regulatory principles and is largely the product of delegates from international bank systems that are hardly worth emulating. These delegates have frequently been motivated by their own domestic agendas rather than a desire to create an accord that improves safety and soundness world-wide. Therefore, we wonder why the U.S. should acquiesce to weakening its bank regulatory standards to those used, and proposed, by other less successful international regimes. Rather than sinking to the lowest capital denominator, we should maintain our high national standards and insist that international bank systems raise their standards.

Proponents of Basel II like to rationalize the new accord's complexity by stating that banking itself has become more complex, and that more sophisticated risk-management models now exist. These justifications overlook the real-world consequences of adopting an inordinately complicated regime, including the resources needed for implementation, the problems inherent in on-going maintenance, the improbability of effective regulation and market oversight, and the competitive pressures that will encourage banks to game the system.

Implementation Concerns

A bank that needs, or elects, to adopt Basel U would have to devote substantial up-front resources to implement the accord. Estimates range from $10 million for smaller banks to upwards of $200 million for large internationally active banks. The number of personnel hours necessary to understand and implement the new accord will be substantial. The vast majority of banks in the US will be unable or unwilling to devote these resources, even if their conservative operations and asset base might warrant a lower risk-based capital charge. Basel U will result in wide variations in capital standards used by banks, with inevitable competitive implications that will be discussed below.

Those banks that can, and do, adopt Basel II, principally the largest banks, will face tremendous challenges in managing the implementation of such a complicated scheme. While the board of directors and senior management are ultimately responsible for approving the Basel II implementation plans, as well as understanding and managing the bank's risks and financial results (which responsibility has been heightened after Sarbanes-Oxley), it is unlikely that any director or executive officer will have more than a surface understanding of Basel II or the bank's own risk-based model. Rather, senior officers and directors will hear truncated reports from time to time, and may even ask questions or alter company strategy in response to the inputs and outputs generated by the bank's black box, but they will not understand the black box itself.

Nor will they want to, either because of the demands on their schedules, the absence of the required technical skills, or the insulation gained from deferring to, and keeping a safe distance from, the experts. At the same time, management would prefer that the bank's expenditures in implementing Basel II could be recouped by creating a model that reduces the bank's capital requirements. While these results-oriented pressures may not be as pronounced during the initial phase-in period, they will exist and will expand with time, especially in the face of competition. This is not to suggest malfeasance by directors or management; it is merely an acknowledgement of the realities that exist at most institutions. Banks will also tend to underestimate risk inputs during the implementation phase, if for no other reason than the empirical data of the last decade has been uncharacteristically favorable as compared to prior economic cycles.

On-Going Maintenance Problems

Only a handful of employees at any bank will understand the most complicated elements of the black box, and virtually no one will understand it in totality. Those individual with the skill set to understand the complexity will probably have an academic bent and will not fully understand the dynamics of each of the bank's business units. They could easily miss important, subtle distinctions or developments that could have a dramatic impact on real-world risk at the bank. Consultants hired to advise the bank about the black box likewise will almost certainly lack experience managing or operating a bank. Even assuming a small group of employees and consultants initially understands a bank's model, personnel turnover will inevitably occur, and their successors will not understand all the tradeoffs, assumptions and other idiosyncracies that have been built into the model. Directors and management will increasingly rely on the expertise and judgment calls of the black box technicians, even though there will be a continual loss of memory about the original details of the model. Later generations of technicians will be less equipped to recognize the problems in the model, or to acknowledge its obsolescence, and will be incented to make incremental "improvements" to the black box to deliver acceptable results.

The bank's model will also require regular data inputs from individuals and departments throughout the bank, even though few if any of them will understand the nuances of Basel II or the bank's model. There will be immense pressures, both explicit and not-so-explicit, for people in the field to report information that will yield a positive result in the model. The flow of information into the black box will inevitably be delayed, as people in the field will want to ensure the accuracy of the data and may be prone to scrub any departmental data that could conceivably have a negative impact on their particular capital requirements. It could take years for subtle changes in a bank's risk management systems to be accurately reflected in the bank's model, and longer still for management to understand the implications. Additionally, in major transactions, such as mergers or acquisitions, a bank may not realistically understand all the integration and other risks for many years, even though management will likely underestimate the negative impact of those uncertainties in their risk-based model until it becomes apparent at a much later time. Many recent crises, including those on Wall Street, have resulted from individuals glossing over, or obfuscating, near-term unfavorable results in the hope that nobody would notice and results would ultimately improve. Basel II gives banks a major incentive to do the same.

Improbability of Effective Regulation and Market Oversight

If the drafters of Basel II had devoted as much time addressing imperfections and inconsistencies in the supervision of capital rules as they did in creating formulas to correct every perceived imperfection and inconsistency in capital calculations, the risks in the global banking system would have been much more effectively mitigated. Unfortunately, Basel II does nothing to improve supervisory standards and is too optimistic about the ability of regulators to supervise the new and highly complicated risk-based capital rules. The U.S. regulatory agencies also are not "proposing to introduce specific requirements or guidelines to implement" the supervisory pillar of Basel II. (ANPR, p. 19) We are concerned with the seeming lack of attention being given to the very practical realities of trying to implement and then regulate the new complex risk-based capital rules. Regardless of the intelligence and good intentions of regulatory agencies charged with supervising a bank's activities, we believe they will not be able to effectively validate a bank's internal methods of risk management and guard against systemic risks.

First, it will be difficult for all the global regulatory agencies to find sufficient talent to fill their ranks, especially when they will be competing for PhD-level expertise against banks with far deeper pockets. Without sufficient staff to understand and keep current on each bank's unique black box, and to conduct the increasingly complex bank examinations, regulators will be forced to make resource allocation decisions that diminish across-the-board oversight.

Second, even if adequate resources are available, unless a supervisor actually participates in building and then managing a bank's black box, it will be virtually impossible to understand all the model's assumptions and anticipate its limitations. At the same time, a supervisor who does participate in the model's development and maintenance is more likely to be co-opted into believing the model works or to be so buried in the details as to overlook emerging risks. Basel II places inordinate faith in singularly skilled and self-assured supervisors who can understand both a bank's intricate model and its unique real-world risks, and can then identify and advocate technical fixes in the face of rebuttals and protests from the dozens of skilled bank employees who spent years developing the models. Without hundreds, if not thousands, of these skilled supervisors throughout the world, the measurement and management of risks in the global banking system will be determined by bank technocrats managing the black boxes.

Third, many of these skilled supervisors will have other job opportunities, leaving later generations without the institutional knowledge necessary to understand the complexities of each bank's black box. It is difficult to imagine that later generations of supervisors will ever be closer than three or four steps behind the bank personnel that manage the model. As a consequence, it will be much more difficult for supervisors to respond quickly when things start to go wrong. Prompt corrective action, one of the most important safety nets for U.S. banks, will almost always arrive too late.

The third pillar in Basel II, that of market discipline, is based on the notion that the market, and/or the banks' own internal based modeling, will ensure that banks maintain adequate capital levels. We certainly support efforts to encourage the market to provide additional oversight of the adequacy of bank capital, but Basel II does not provide any meaningful protection in this regard. As proposed, we do not believe the markets will be in any better position than the regulators to understand all the implications of a bank's risk-based model. If anything, they will be worse off in having to rely on the disparate black boxes. Also, since markets do not always operate efficiently or with perfect information, market disclosure and discipline is unlikely to identify, and may tend to minimize, problems in the banks or the banks' models. Rating agencies have been criticized for reacting too slowly during crises and for being under pressure to deliver good ratings in order to continue to win business. Accordingly, this form of market discipline will function least when needed most. Additionally, market oversight has not proven particularly effective at preventing other crises, as market participants selectively overlook potential problems during the build-up of speculative bubbles. Finally, any bank that develops an internal risk management model will want to design it to be market sensitive. If every bank does so, then all the models will be sensitive to the same market information, causing institutions to all react the same way during a crisis.

Competitive Pressures

Regulatory capital is a key driver of return-on-equity and, therefore, profitability. At the same time, it is axiomatic that banks cannot grow their asset base without correspondingly increasing their capital levels (since capital thresholds are expressed as a percentage of assets). While many conservative banks maintain capital levels in excess of regulatory thresholds, other banks are more aggressive at managing their capital levels in order to grow their asset base and/or free up capital for other purposes.

Contrary to what some Basel II proponents have said (that levels of required capital do not have a competitive impact), capital is a fundamental financial metric that all companies actively measure, manage and massage in order to improve their earnings and competitive position. The pricing and structure of commercial loan transactions is very much influenced by the impact on the counter-party's capital. Our bank has entered into transactions with other financial institutions that charged higher prices if the transaction required higher capital. Additionally, any commercial bank borrower is familiar with 364-day credit facilities that roll over each year, a structure that was essentially invented solely to allow commercial banks to avoid a higher capital charge on loans. There are few, if any, transactions in which a bank does not consider the impact on the bank's capital.

In the face of both international and domestic competition, a large U.S. bank under Basel II would have every incentive to create and maintain a risk-based model that allows it to reduce capital levels below both its Basel I level and the capital levels of its competitors. Failure to do so could not only jeopardize the bank's profitability relative to its peers, but could also enable competitors to boost their asset base and invest freed-up capital elsewhere. Even if only a few large banks start out trying to game the system, others will find it difficult to stay on the sidelines. The result could be a race by the nation's largest banks toward the lowest amount of capital reserves. Basel II banks will have an incentive to find or create the capital model that requires the least amount of its capital, and will even be encouraged to find ways to exchange their high-capital assets with other banks whose own risk-based models (or supervisors) would accommodate a lower risk-based capital charge for those same assets. As a consequence, instead of ensuring that sufficient capital is available to address risks, Basel II's do-it-yourself capital measurements will have distorted economic incentives and will lead to greater risk-taking and greater concentrations of risk.

The lower capital levels that large banks obtain under Basel II also will inevitably threaten the viability of small to medium-sized banks. These smaller banks perform a critical role in local economies, especially as lenders of residential, small-business and other retail products. Since most of these smaller banks will remain under Basel I, they will have difficulty competing against bigger Basel II banks that benefit from reduced risk-weighting for these same assets. Furthermore, small Basel I banks would be likely takeover targets for Basel II banks that believe they could deploy Basel I bank capital more "efficiently." Basel I bank, that survive will find it more difficult to compete for quality assets and could be left with riskier assets, lower credit ratings and higher costs of liabilities.

The competition described in the preceding paragraph also could destabilize the nation's housing market, one of the few bright spots currently in the U.S. economy. Because of the lower capital requirements under Basel II for residential mortgages, large banks may increase their asset base allocated to mortgages, price mortgage products below what Basel I banks can offer, and enhance their ability and desire to acquire small lenders. They also may increasingly try to categorize consumer and other credit as mortgage-related assets, and competition in pricing could make the system vulnerable to a speculative bubble. With industry consolidation, products also may become further standardized, in which case consumers and businesses would have fewer choices. The concentration of mortgage assets in just a few institutions would further heighten potential system risk.

Recommendations and Conclusion

The drafters of Basel II purportedly set out to devise a more efficient and effective risk-based capital model; instead, they have crafted a risky model that inevitably will lead to capital deficiencies. The objectives of any capital accord should be to promote stability by requiring that sufficient capital be available, level the playing field, and enable interested parties (boards of directors, management, regulators and other market participants) to effectively monitor capital levels and intervene if necessary. Basel II will not achieve this result, because of its complexity, its high potential for manipulation, and the impracticalities of effective regulation and market oversight.

A much better way to proceed would be to make specific incremental changes to Basel I in areas where the existing accord currently falls short and to improve the imperfections and inconsistencies in the supervisory process. For the reasons discussed above, we believe that capital requirements could be more closely aligned with actual risk, without resorting to Basel U's bank-driven models, simply by increasing somewhat the number of risk categories and recalculating specific risk-weightings using modem risk management techniques. This modernized Basel I approach would avoid the unnecessary complexity and competitive implications of the Basel I/Basel II bifurcated regulatory framework being proposed.

At the very least, any capital accord should co-exist along with a minimum leverage requirement that applies to both domestic and international banks. We agree with the position articulated in the ANPR that the existing leverage ratio requirements under prompt corrective action legislation and implementing regulations should be maintained, including a minimum 5% leverage ratio to be classified as "well-capitalized." Moreover, there should be legislation or binding provisions that would prohibit the leverage ratios from being reduced or waived without legislative action. Among other things, a minimum leverage ratio ensures that, regardless of the risk-based capital model used by a bank, there is a base level of capital available in the event of a crisis. It would serve as a counter-balance to unexpected risks that might arise or the manipulation created by either Basel I or Basel II. The U.S. regulatory agencies properly have decided not to "place sole reliance on the results of economic capital calculations for purposes of computing minimum regulatory capital requirements." (ANPR, p. 10) Because of the added safety and soundness protection that a leverage ratio provides, we would urge American representatives in Basel II to insist that a leverage ratio be applied to all banks world-wide under the accord.

As. a matter of sound public policy, we believe it is infinitely wiser for a capital accord to err on the side of overcapitalized banks, rather than giving banks worldwide the ability and incentive to reduce capital levels as low as possible. Unless the U.S. dispenses with Basel II's fanciful scheme, the seeds of the next bank crisis will have been sown, watered, and be well along in destructive growth.

Sincerely,

Herbert M. Sandler
Chairman and Chief Executive Officer
World Savings Bank
Oakland, CA